Where Does Technical Analysis Fit in Investing?

The basis of long term investing is the assessment of fundamental value. Those who choose to trade stocks over the short term focus on changes in market sentiment and use technical analysis indicators in order to profit from brief price fluctuations up and down. A long term investor uses the concept of intrinsic stock value in order to choose investments that will provide profits over the long term. Where does technical analysis fit in investing or does it even have a place?

What is Technical Analysis?

Hundreds of years ago in Japan when there were Samurai, there were markets for trading rice. Traders normally looked at how good the harvest would be, if the economy seemed strong, and other fundamental factors that drive market prices. Then one trader noticed that simply by looking at price patterns he could predict where prices would go next. This was the first instance of technical analysis and that system is still in use today as the Japanese Candlestick system. Technical analysis today has many tools with their focus on variations in trading volume and prices. This approach relies heavily on statistical trends. The rationale of technical trading is that the market already knows all of the necessary fundamentals and technical indicators predict how it will react at any given point. Common indicators include moving averages, price to volume indicators, and tools such as the stochastic trend.

Where Does Technical Analysis Fit in Investing

What Is Market Sentiment?

The stock market continually tries to predict the future. Traders and investors have access to the same information but their interpretations are different. This is market sentiment. One can access useful market sentiment data in order to help predict where prices are likely to move in the short term. Greed and fear are the eternal enemies of successful trading and investing and market sentiment indicators help a trader see when the market has become irrationally fearful or greedy at which time smart traders take a contrarian view and typically make profits. Warren Buffett has famously said that the smart investor is cautious when the market is excited and aggressive when the market is fearful in its extreme.

Using Technical Analysis to Enhance Investing Profits

Every time that one buys or sells a stock, they pay a commission and fee with the exception of when they buy directly from the company through their dividend reinvestment plan. Although one can make a lot of money by swing trading stocks, most folks cannot time the market all that well and tend to eat up their trading capital with excessive overhead. But there are times when the use of market sentiment and technical analysis can help investors multiply their long term profits. Many times bear markets are the key to future wealth. The market is heading down and panic is spreading, especially among those investors who are highly leveraged. Fundamental analysis of a stock tells you that it will be a sound investment bringing in constant returns for years and years. However, the market, and that stock, are still heading down. Here is where an investor can put on their technical trader hat, look at market sentiment data and technical indicators to assist in predicting when the market will hit bottom and start back up. If the investor can pick the right moment to step back into the stock in question they could double or triple their long term profits. The alternative is to use a dollar cost averaging approach which keeps one in the market but does not optimize the point of market reentry.

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